How To Reinvest Your Vodafone Special Dividend

Today, Vodafone hands almost £4 billion to its owners. What should they do with this cash?

For two reasons, today (Friday, 3 February 2012) is a very special day for the shareholders of telecoms giant Vodafone (LSE: VOD).

A dotcom mega-merger

First, Friday is the 12th anniversary of German rival Mannesmann agreeing to be bought by Vodafone in a £112 billion ($183 billion) all-share deal. At that time (February 2000), this was the largest merger in corporate history. Indeed, it catapulted Vodafone into the prized slot of being the UK's largest listed company.

Alas, this mega-merger took place right at the top of the dotcom bubble and, soon afterwards, Vodafone's inflated share price began to tumble. Twelve years on, Vodafone is merely the fourth-largest company listed on the London Stock Exchange, worth almost £87 billion as I write.

A £3.6 billion payday

The second reason for Vodafone shareholders to be pleased is that the company has dumped an extra £2 billion in cash into their laps today. This comes in the form of a special dividend of 4p per share. Given that Vodafone has over 50 billion ordinary shares in issue, this is one of the largest one-off dividends ever paid to British shareholders.

However, the cash payout to Vodafone's owners doesn't stop there. In addition, the company today paid out its usual half-yearly interim dividend, which adds an extra 3.05p per share. That's another £1.6 billion in cash flowing into the bank accounts of Vodafone shareholders this morning!

How can Vodafone afford to pay out such an enormous sum to its owners? Its ordinary dividends are well covered by its strong cash flow. However, the special dividend is a bonus coming from a £2.8 billion dividend Vodafone received on 31 January from its 45% holding in leading US mobile phone firm Verizon Wireless.

What to do with this windfall?

Of course, being one of the FTSE 100's mega-cap firms, Vodafone's shares are very widely held, both by professional fund managers and private investors. Hence, this £3.6 billion cash payout will be shared by millions of British and foreign investors.

Therefore, the big question is: what should shareholders do with this bumper bounty? Here are six ideas to get you started:

1. Pay off debts

Although the Bank of England's base rate has been firmly stuck at 0.5% since March 2009, credit and store cards have been getting increasingly expensive. Indeed, a typical credit card now charges interest of over 19% APR, which comes to almost 1.5% a month.

Therefore, if you've been landed with a bumper Christmas credit-card bill, then it makes sense to use any spare cash to repay this debt as quickly as possible.

2. Reduce your mortgage

Just as savings rates have plunged since the financial crisis, so too have mortgage rates.

Even so, it still possible to earn a decent -- and guaranteed -- return by using spare cash to reduce the size of your home loan. For example, a higher-rate (40%) taxpayer with a mortgage costing 3% a year would need to earn 5% from a taxed savings account to beat the return on offer by paying off part of his home loan.

3. Strengthen your savings safety-net

If you have little or no debt, but have less than, say, three to six months of living expenses in cash, then you could beef up your savings. With a Best Buy cash ISA, you could earn interest of over 3% a year, with no tax to pay.

4. Buy more Vodafone shares

Of course, you could use this cash payout from Vodafone to buy more of its shares. Like many major companies, Vodafone operates a DRIP -- a Dividend Reinvestment Plan -- that allows shareholders to take their dividends in shares, rather than cash.

Through this scheme, Vodafone uses the cash from dividends to buy more shares in the open market for DRIP investors. This service costs 0.5% of the total value of your dividend payment (no minimum charge), with a further 0.5% paid in stamp duty reserve tax. Having joined the DRIP, future dividends will continue to be reinvested until you inform the DRIP administrator.

5. Buy more dividends

If you're a keen dividend-seeker, then there are plenty of other mega-cap companies offering generous dividends to patient shareholders. Indeed, in a quick search of the blue-chip FTSE 100 index of Britain's corporate elite, I found 14 other major corporations with yearly dividend yields of 5% or more. Thus, instead of adding more Vodafone shares, you can use your cash windfall to buy other high-yielding shares.

6. Dodge tax

Last but not least, this cash windfall may also land you with a tax problem.

For basic-rate (20%) taxpayers, there is no extra tax to pay on dividends paid by directly held shares, thanks to a notional 10% tax credit. However, higher-rate taxpayers lose a quarter (25%) of their net dividends (22.5% of the gross dividend) in additional tax.

Therefore, if you'll be forced to pay tax on this Vodafone hand-out, then learn your lesson now. Instead of holding dividend-paying shares directly, put them inside a tax-free shelter such as an ISA or SIPP. By doing this, future dividends will be entirely free of tax, and will no longer have to be declared on your tax return.

What I said is completely true: strictly speaking, dividends are not taxed inside ISAs. As I've explained before, there is no direct tax on ISA dividends, as such.

When a dividend is paid, a 'notional tax credit' of a ninth of the dividend is given to the shareholder. For example, a dividend of 9p attracts a 1p notional tax credit. Thus, the 'gross' dividend is 10p and the 'net' dividend is 9p.

This 10% tax credit is enough to extinguish any tax liability for non-taxpayers and basic-rate taxpayers.

However, higher-rate taxpayers must pay tax on dividends paid outside of ISAs at a rate of 32.5%. This is made up of the 10% tax credit, plus a further tax bill of 22.5% (or a quarter of the net dividend).

Until 2004, investors could reclaim this 10% notional tax credit for dividends received inside ISAs and other tax shelters. Alas, this is no longer the case.

Thus, there is no direct taxation of ISA dividends, as such. Instead, thanks to 'the dour Scot' (Gordon Brown MP), ISA and SIPP investors and non-taxpayers can no longer reclaim the 10% notional tax credit.

So.... if you hold this within an ISA you'd be (net net you and the company) 10% better off if they did a buy-back? Not that I'm in any advocating one - just from a numbers perspective it would be better as HMRC wouldnt get their hands on the 10%?

To the pub with my some of my Yoda money I shall be going tonight. Mmmmm. The Force of Guinness I shall be feeling...

Now look to the blue Verizon we all must.

Sorry.

On the subject of credit cards, online accounts are a godsend. I don't wait for the statement, just log in from time to time and pay off the stated balance. Haven't paid interest on a CC in years. They must hate me and my airmiles - sorry, Avios.

US jobs figs just out - **** me readers... How's that for where you can shove analysts' consensus?

So it's best for most people to use their ISA wrapper to shelter income-bearing assets. Investments that are unlikely to trouble you with CGT any time soon, so half the sparkle-sell on the concept is gone. Oooh, could it possibly have been a typical "clunking" move to persuade investors into, hmm, I dunno, gilts?

Vodafone may offer dividend reinvestment at 0.5%, but my Vodafone shares are held in an ISA with Halifax. In line with their policy of increasing greed, Halifax recently increased the charges for the dividend reinvestment programme from 1 to 2%.

Hardly competitive, but then the ISA rules allow financial service providers to charge high fees for moving the account elsewhere. Effectively the customer is trapped as they turn the screw on fees.

Hi jaizan. I've had the same problem. I've moved to iii (which is 1%). They give you up to £100 as a bonus to transfer in. Halifax (as iweb) wanted £48 to close +£15 per item to transfer out. Still lose but will be better over time with re-investment of dividends.

Hi Pitydafool, thanks for the advice. How long did Halifax take to switch the funds over?I've got 14 separate items in the Halifax Isa, so £248-100= £148 to move the account. Perhaps I could get payback within 2 years, if iii don't put the fees up.Of course, iii are run by Halifax.

Currently, I just wait for over £1000 of dividends to roll in, then make a normal trade.

ANuvver - it's a myth that credit card companies hate customers who pay off in full each month. They get their money in charges to the retailer - around 3-5% for up to 6 weeks credit. A mouthwatering APR.

Fair point, cafc7. So maybe they don't hate me. But I'm sure they'd love me long time if I ran a balance!

Some ugly ISA stories here. I'm with jaizan - I selectively reinvest in meaningful chunks (to minimise dealing cost). A DRIP may have the advantage of convenience, but we can hardly criticise share buybacks if we're willing to roll the dice on SP with automatic reinvestment programmes.

If you're only able to invest/reinvest around £10k a year, then you might as well use an ISA for everything. If you've a bit more to play with, I don't know that I'd waste the tax efficiency of an ISA allowance on an income play like VOD. If you've a hell of a lot more to play with, you probably don't care about what I think!

Income-bearing investments inside an ISA (typically bonds, property REITs and a few other bits and pieces) are paid gross and don't need to be added to your salary etc, when it comes to declaring a figure for income tax.

I'm really talking about asset allocation. If you accept that you should hold at least some bonds, then I think most people would derive maximum tax efficiency by considering that kind of investment as the first candidate for ISA wrapping. Of course, your mileage may differ.

Unless you're going to get hit for the higher rates on dividend income, there's no benefit to holding a high-yielding dividend stock in an ISA. I mean, something like VOD is unlikely to leave you with a CGT problem anytime soon, is it?

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